Spread Your Risk

Larry Stalcup

Fri, 2005-04-01 12:00

The window to market fed cattle isn't as open as most would like. So, some feeders are using a combination of options spread to widen that margin, even if there's a little risk involved. Non-hedgers have seen their cash or grid-type sales pay off for the most part for nearly two years, excluding the late 2003 BSE scare. But with feeder cattle higher throughout 2004 and into 2005, protecting breakevens

The window to market fed cattle isn't as open as most would like. So, some feeders are using a combination of options spread to widen that margin, even if there's a little risk involved.

Non-hedgers have seen their cash or grid-type sales pay off for the most part for nearly two years, excluding the late 2003 BSE scare. But with feeder cattle higher throughout 2004 and into 2005, protecting breakevens could be a smart move.

“There just haven't been many good hedging opportunities,” says Scott Hall, owner of Circle Three Feed Yards, Hereford, TX, as he views eight-weight feeders push $100/cwt. on a satellite sale.

“We've worked through the past few years without using futures or many options but sometimes that type of program won't work,” he says.

In January, Hall decided to make some futures options moves to shore up the price on cattle coming out of his yard in May and June. He's looking at similar protection programs for summer cattle.

His strategy was to buy an at-the-money put option, then sell an out-of-the-money call option and an out-of-the-money put option. The idea is to have reasonable price protection without laying out $30+/head.

“I try to keep the cost of protection at about $1/cwt.,” he says. “For some cattle that will finish in May and June, we looked at buying a June $80 put for $3 (an at-the-money price in early January). To offset that $3 premium, we sold an $88 out-of-the-money June call for 70¢, and a $72 out-of-the-money June put for 90¢. That gave us $80 price protection for a cost of $1.40/cwt.”

That strategy gives him a 16¢ up-or-down window from his $80 level. However, margin calls are required if the market moves up or down. If there are signs of sharp moves in the market, he'll roll or move out of his out-of-the money positions to protect against a major margin call.

“Earlier this year, you could buy a $78 August put option for $2.85 and sell an $84 August call for about $2. That provided a $78 floor for about 85¢ cwt.,” he explains. “For a $74 put, the premium charge was about $1.70. That, and selling the $84 call for the $2 price, would provide a pretty good window for a cost of only about 30¢. Those types of strategies can protect your breakeven and keep the banker happy.”

LRP as a protection tool

There are other price protection choices. USDA's Livestock Risk Protection (LRP) program provides a tool for even the smallest producer or feeder in 19 states.

Darrell Mark, University of Nebraska livestock marketing specialist, has conducted producer/feeder meetings on the program's benefits, which works much like a simple put option for price insurance. LRP insurance is purchased through a crop insurance agency.

“Initially offered in June 2003 to fed-cattle producers in Nebraska, Iowa and Illinois, LRP indemnifies against declines in cash fed cattle sales prices, as measured by a regional weekly weighted average cash slaughter steer price,” he says. “Producers can use LRP to protect against declines in their own cash sales price but still benefit from price increases, similar to using put options.”

In LRP guidelines, the feeder or producer establishes a floor price level for his cattle at their time of sale. The coverage price is then compared to “Actual Ending Value” (AEV), which is measured from the five-area weekly weighted average 35-65% Choice live steer price.

The insurance contract pays an indemnity to the producer if AEV falls below the coverage price. The amount of the indemnity is the difference between the coverage price and AEV.

“If, for example, the coverage price of $78 on fed cattle to be marketed 17 weeks into the future is above the AEV of $75 at the end of the period, the feeder or producer gets paid a $3/cwt. indemnity,” he explains.

Mark notes the premium charge is similar to that of a put option premium, even with about 13% paid by USDA. The program applies for one head to 2,000 head of fed cattle at one time, and up to 4,000 head/year.

“It can be a good program for the small feeder or producer who doesn't want to deal in a 40,000-lb. futures contract,” he says.

Of course, one strategy could be to not buy feeder cattle if the price is too high.

“It's hard for the commercial feeder to not have cattle,” Mark says. “But for the farmer-feeder, buying feeder cattle that can't produce a breakeven price isn't a good idea.”